MACROECONOMICS 1

Oil Crisis in Mexico (2006-09)

Mayank Kumar 1923022

Christ (Deemed to be University)

MACROECONOMICS 2

Oil Crisis in Mexico (2006-09)

A Brief History

When oil was discovered in Mexico's Faja de Oro in 1910 by the British-owned company

Mexican Eagle, an oil rush began that spread far beyond Mexico's borders. The instantaneous

and fabulous wealth created for Sir Weetman Pearson (later Lord Cowdray) by the discovery of

the Potrero de Llano well meant that other, primarily U.S., firms entered the Mexican market

seeking to discover such untold riches for themselves. In the space of a few years, Mexico had

become the world's second largest oil producer, supplying one fifth of U.S. demand.

Although Mexico was soon left behind in terms of production levels and technology as

compared to US, its nationalization and the creation of PEMEX (Petróleos Mexicanos) in 1938

set a precedent that would be followed years later around the world. The National Oil Company

(N.O.C.) would become a model copied at different times and places, involving very different

business strategies and rationales, and ultimately the N.O.C.'s would come to challenge the

privately-owned International Oil Companies (I.O.C.'s) in international markets due to their

control of reserves.

Problems and Looming Crisis

Cantarell's fall over the past few years has been precipitous. From a high point of 2.136

million barrels per day (bpd) in 2004, production had declined to only 545 thousand bpd by the

end of 2009. Cantarell was the mainstay of Mexican production for almost three decades, and its

rapid decline has pushed PEMEX to scramble for alternatives. Lacking the technological and

technical capacity to venture successfully into deep water exploration, where it is believed most

of Mexico's remaining reserves are to be found (estimated between thirty to fifty billion barrels),

PEMEX has had to look to existing wells to boost production.

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This loss of over one and a half million barrels a day in oil production has been partially

offset by increased production in fields such as KuMaloob-Zaap (K.MZ.), which in 2008

surpassed Cantarell as the nation's highest producing oil field and continues to pump out around

850 thousand bpd. K.M.Z. will begin to decline within the next three to five years, but in the

short term, it has helped to reduce the catastrophe for PEMEX.

International oil prices Mexican oil rig

Index 31 Dec 2002 = 100 Millions of barrels per

day
Ol
i 500 4
450 Production
4
400 Exports
3
350
3
300
250 2

200 2
150 1
100
1
Aug-04

Aug-09

50
Dec-02

Feb-07

Dec-07
Apr-06
Jun-05
Oct-03

Oct-08

0
1980

1995
1998

2007
1986

1989

1992

2001
2004
1983

Source: Bloomberg. Sources: Ministry of Finance (SHCP); Bank of Mexico.

Monetary and Fiscal Policies

Fiscal Policy

The years before to the financial crisis, the Mexican Government had followed a

balanced budget rule in line with the Federal Budget and Fiscal Responsibility Law (Ley Federal

de Presupuesto y Responsabilidad Hacendaria (LFPyRH)). Thus, when the global crisis escalated

in September 2008, the budget was balanced. However, there were a number of sources of

vulnerability for the fiscal accounts. First, a high dependence of government revenues on oil

income, given that between 30 and 40% of public sector revenue comes from crude oil exports.
MACROECONOMICS 4

Second, the deterioration in the outlook for economic activity was expected to reduce tax

revenues. Third, the rigid structure of public expenditures leaves little room to adjust them. In

particular, Mexico had enjoyed a windfall of oil revenues for several years, and a significant part

of those extraordinary revenues was used to increase public spending, for example in social

programmes, which are extremely difficult to adjust.

As the crisis began to hit the poorest segments of society, the federal government made

efforts to adopt measures to try to attenuate the adverse impact of the crisis on economic activity,

particularly on low-income families. Those measures included increasing public expenditures on

infrastructure, freezing household energy prices, decreasing industrial electricity tariffs, and

implementing programmes to support employment. In order to implement such measures, the

budget for 2009, set out in light of the LFPyRH, was modified, allowing it to shift from a

balanced budget to a moderate deficit.

However, by mid-2009, the economic recession had turned out to be deeper than

anticipated and oil prices were also lower than had been expected. Under those conditions, there

was a substantial decline in public sector revenues. This situation, along with the aforementioned

downward rigidity of public expenditures, weakened the country’s fiscal position, which limited

Mexico’s access to international credit markets to an even greater extent.

It thus became urgent to adopt measures to close the increasing gap in the fiscal accounts.

At first, the federal government used non-recurrent revenue sources such as savings previously

made in the oil revenue stabilisation funds and exercising the oil price hedging options.

However, the government also expressed the need to implement fiscal reform in order to

structurally strengthen public finances. The Mexican Congress approved fiscal tightening

measures for 2010, including some public expenditure cuts and higher taxes. Among other
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things, these included a permanent increase in the general VAT rate, permanent and temporary

increases in excise taxes, temporary increases in income taxes, and limits on tax deferral

mechanisms for corporate groups. The fiscal effort amounted to approximately 2% of GDP.

This fiscal consolidation package was implemented under an extremely adverse

environment, characterised by a sharp contraction in economic activity. However, it improved

the country’s fiscal position and was crucial in restoring investors’ confidence. It is worth

mentioning that the recent concerns about the sustainability of the fiscal accounts in a number of

euro area economies highlight both the risk of weak fiscal positions, and the urgent need to

implement corrective measures, even under extremely difficult conditions.

Monetary policy

The challenge for the central bank was to help restore the orderly functioning of a

number of financial markets in order to prevent a systemic risk episode, and at the same time

avoid a deterioration in inflation expectations, which could put price stability at risk.

During the first half of 2008, the sharp increase in the international price of commodities

led to higher inflationary pressures in Mexico. At the time, economic activity had not been

significantly affected by the crisis originating in advanced economies, and the Bank of Mexico

decided to tighten monetary conditions. The goal for the overnight interbank interest rate was

raised from 7.5% in June to 8.25% in August. These actions were partly preventive, as they were

implemented to avoid the increase in inflation from affecting inflation expectations.

In the second half of 2008 the global financial crisis escalated, negatively affecting

economic activity and disrupting the normal functioning of the financial markets. The

stabilisation of domestic financial conditions was, indeed, crucial. At the same time, the

following factors contributed to a further worsening of inflation in the last few months of 2008:
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i. Increases in international commodity prices affect domestic prices with a lag;

consequently, their effects on consumer inflation remained present during the last quarter of

2008. ii. The domestic currency depreciation following the events of September 2008 also

affected inflation.

Under this scenario, although the outlook for economic activity began to deteriorate, the

Bank of Mexico decided to leave its policy rate unchanged, mainly in response to increasing

concerns about inflationary pressures and their potential negative impact on inflation

expectations. At the time, the central banks of advanced economies had already implemented

aggressive policy rate cuts. Therefore, the Bank of Mexico’s decision contributed to widening the

interest rate differentials among Mexico and developed economies, particularly the United

States. This implied a further tightening of the monetary policy stance in Mexico.

By early 2009, inflation appeared to reach a peak and started to fall, while prospects for

growth deteriorated. Lower food and energy prices and a wider output gap reduced inflationary

pressures, although inflation remained higher than in advanced economies. The balance of risks

deteriorated significantly, tilting towards the side of economic activity, while inflation

expectations remained relatively well anchored. The weak economic activity during the first

quarter of 2009 worsened in the second quarter of that year. This poor performance led to a

downward revision in growth prospects for the year as a whole. A potential recession became the

main cause for concern. Thus, the central bank began a loosening cycle, rapidly cutting the

policy rate from 8.25% in January to 4.5% by July.

Final remarks
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Policymakers faced the challenge of restoring orderly conditions in the financial markets: timely

and decisive actions were needed. In particular, coordination among the different authorities was

crucial, given the need to use different policy instruments. In this setting, several measures were

implemented to provide liquidity in both domestic and foreign currency, as well as to restore the

normal functioning of a number of domestic financial markets and reduce exchange rate

volatility. The policy response in Mexico helped to contain the financial crisis and prevented the

drop in liquidity from evolving into insolvency problems for some domestic financial

institutions. This situation would have significantly threatened the stability of the Mexican

financial system. The Mexican banking system ultimately proved to be very resilient to the

shocks facing the global financial system. In fact, throughout the worst period of the crisis,

Mexico continued to be in the black with capitalisation indices well above those required by law.

The Mexican economy had to adjust to an environment characterised by lower external revenues

and reduced access to external financing. It seems that the fiscal and monetary policy mix used

was the appropriate macroeconomic policy stance, as it led the economy through the required

adjustment with the lowest cost. Furthermore, the tax reform approved by Congress improved

the fiscal position of the country, which helped to reduce the risk perception of the economy,

while also diminishing pressures on non-tradable goods inflation. Central bank actions were

geared to restoring orderly conditions in the domestic financial markets and monetary policy was

loosened as the balance of risks tilted towards economic activity. The use of monetary policy to

support economic activity, however, was limited by the need to contain inflation expectations

generated by the nominal exchange rate depreciation and the indirect tax hike.

References
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1. Wood, D. (2010). THE ADMINISTRATION OF DECLINE: MEXICO'S LOOMING

OIL CRISIS. Retrieved October 31, 2020, from

https://scholar.smu.edu/cgi/viewcontent.cgi?article=1483&context=lbra

2. https://www.coha.org/mexico-an-oil-nation-in-crisis/

3. https://www.spglobal.com/platts/en/market-insights/latest-news/electric-power/103020-

bp-to-shut-australian-kwinana-refinery-convert-it-into-fuel-import-terminal

4. https://www.bis.org/publ/bppdf/bispap54q.pdf

5. https://www.sjsu.edu/faculty/watkins/mexico82.htm

6. https://finshots.in/archive/the-mexican-standoff/